It goes without saying, I suppose, that financial markets regulation has always been something of a conundrum – the markets have always been global, to a greater or lesser degree, and regulations have always been national or regional. But it does seem that today more than ever the problem is exacerbated. After the financial panic of 2008-09, every regulator and every government seemed to embark on a market reregulation binge, and managed to do it without much regard for what everyone else was doing.

It goes without saying, I suppose, that financial markets regulation has always been something of a conundrum – the markets have always been global, to a greater or lesser degree, and regulations have always been national or regional. But it does seem that today more than ever the problem is exacerbated. After the financial panic of 2008-09, every regulator and every government seemed to embark on a market reregulation binge, and managed to do it without much regard for what everyone else was doing.

As a result, everyone in the markets – venues, dealers, brokers, asset managers and clearing houses – are facing a regulatory crossword puzzle, with some significant penalties for getting any of the words wrong. Many of the challenges start with the applicability of the rules. There are actually three parameters which govern that applicability. The first is the regulatory venue of the investment firm or firms. Second is the regulatory venue and status of any customer for the services. And finally there is the regulatory venue of the instrument(s) involved. When we start combining those parameters, we get a dizzying array of possibilities.

These parameters in turn affect the requirements contained in the new EU regulations: MiFID II/MiFIR, and MAR/MAD, as well as regulations in other major market venues, like the US, Canada and Australia. Among the more important EU requirements are: the trading obligation, the transaction reporting obligation, the pre-trade transparency obligation, the post-trade transparency obligation, the best execution obligation, and the obligation to monitor customer activity for market abuse. Some of these obligations appear to be triggered by where the customer is, some by where the firm is, some by the venue of the instrument, and some may actually be in conflict.

Of course, other market regulators have their own versions of these requirements, so let’s look at some simple combinations first. The first is a firm dealing with a customer in instruments, all of which are domiciled in the same jurisdiction. It seems pretty clear whose rules apply, except that we need to be careful if one of the parties is a subsidiary of a foreign parent, where the trade might have a significant impact on the parent or its regulator.

The First Complication

But if we start changing things, it quickly gets more complicated, so we will need to look at some “simple” examples. For instance, let’s look at an EU firm dealing with an EU customer in a non-EU instrument. Barclays executing a trade for Scottish Widows in a US stock, for example. Simple enough, right? One would think that there’s no MiFID trading obligation, unless somebody in the EU also lists that stock. And, we hope, no EU reporting obligation. But what about best execution? Since the customer is an EU person, albeit a professional, what best ex obligation does Barclays have? If Barclays is acting a principal in this trade, does the MiFID best ex apply at all? And, whose market abuse regulations apply, the EU’s or the US’s – or maybe both? Oh, I almost forgot, what is Barclays’ obligation regarding pre-trade transparency? If it did this trade as principal, must it expose the quote it showed the customer to the rest of the EU market, even though the trade was done in its NY office?

The Second Complication

Just for fun, let’s reverse the parameters. A non-EU firm executing for a non-EU customer, in an EU instrument. Deutsche Bank Securities, Inc (an SEC-registered broker/dealer with no presence in the EU) selling a German Bund for a US hedge fund. To begin with, even if the bund is listed in the EU, the MiFID trading obligation doesn’t apply to fixed income. But we need to know whether the trade with the hedge fund was done as principal, with DBSI doing a matching trade with its German affiliate. Or was it done as agent, with DBSI passing the order through to an EU broker for execution? If as agent, was it done omnibus, where the executing broker (perhaps its Swiss parent) only knows DBSI as the selling party, even though the actual seller was the hedge fund? Or was it done on a disclosed basis?

Let’s say it was done as agent, under the omnibus arrangement. The selling party, the hedge fund, isn’t bound by any MiFID rules, and its agent, DBSI, isn’t either, since it isn’t an “investment firm” as defined by MiFID. But who must then file the trade report with the EU repository, since that is required for trades in EU instruments, but neither party to the trade is in the EU? Oh, and the monitoring for market abuse, who does that? If the original seller is a US person, and the broker who knows its identity isn’t subject to MiFID, can anyone be held to the monitoring obligation?

But wait, it turns out that DBSI bought the bonds from the hedge fund as principal. The trade with the hedge fund is totally outside of MiFID and MAR, and totally within the purview of the SEC, except that the SEC doesn’t regulate trades in EU securities. And ESMA is very much of the opinion that this trade is subject to MAR. Does DBSI’s trade laying off the position fall under MiFID? And just to complicate it a bit more, let’s say that DBSI sold the bunds as principal to its EU affiliate, raising the question of whether inter-affiliate trades are covered, and by which regulator.

Now Some Conflicts

Now it’s time to look at some internal conflicts, such as between MiFID’s best ex and trading obligations. Let’s start with the rule language.

Article 27 of MiFID II requires firms to “take all sufficient steps to obtain, when executing orders, the best possible result for their clients, taking into account price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order.” One thing to recognize right away is that this applies to the execution of orders. If a dealer makes a market to a customer, and the customer executes off that market, there is no order involved. The second factor is that the rule is triggered by where the customer is domiciled.

On the other hand, Article 23 of MiFIR says that firms shall “ensure the trades it undertakes in shares admitted to trading on a regulated market or traded on a trading venue shall take place on a regulated market, MTF or systematic internaliser, or a third-country trading venue assessed as equivalent.” And Article 28 says, in a very convoluted way, that trades in EU listed derivatives between two FCs or an FC and an NFC+ must be traded on a venue, which by(?) definition includes OTFs and SIs. Collectively, these requirements are generally called the “trading obligation.”

The most obvious possible conflict between best ex and trading is where a stock is dually listed, and one of the venues outside the EU isn’t assessed as equivalent by ESMA, but has the best price. If a non-EU customer gives a broker subject to these rules a market order in this stock, under EU rules the firm must execute it on the EU venue, no matter where the best price is. However, this will probably violate the best ex requirement in the customer’s home country. If an EU customer gives the same order, the broker must then violate either the EU best ex or the trading obligation.

None of the regulations I have seen anywhere offer any guidance on how to resolve this conflict. Some people have tried to read between the lines of the rules, saying that the trading obligation language is more explicit than the best ex language, so trading obligation trumps best ex. Others say that their obligation to the customer trumps any rule about where you can trade. Either way, we’ve clearly found a rock and a hard place for the firm. Which would you rather deal with: an angry customer or an angry regulator?

Another possible conflict of the same type is a firm doing a trade in a swap that is listed in the EU with an NFC+ counterparty, where the best price the firm will pay is available in an OTC market outside the EU as well as on the EU venue. If the NFC+ customer is not a member of the trading venue, then the mandated venue execution is made worse by having to pay a commission to trade with the same party it could otherwise trade with net.

Another conflict is between the EU pre-trade transparency and best ex requirements. Article 3 of MiFIR requires market-makers to “make public current bid and offer prices and the depth of trading interests at those prices…for different types of trading systems including order-book, quote-driven, hybrid and periodic auction trading systems.” Of course, different instruments trade on different kinds of markets, so we should be mostly concerned with instruments that don’t trade on central limit order books (CLOBs), since CLOB bids and offers are public already. The first thing to understand is that these instruments can trade one of two ways, on an ECN, called an organized trading facility (OTF) in MiFID, or direct with a market-maker, who is called a systematic internalizer (SI). In the current world, most ECNs or OTC market-makers operate in a request-for-quote (RFQ) mode, where dealer bids and offers are only available upon request.

The general interpretation of the rule language (and there is very little clarification in the various technical standards) is that any quote, bid or offer given by a market-maker to a customer must be available to and actionable by everyone, including other market-makers. (As an aside, ESMA was told early on that this interpretation would likely double the market spreads in affected bonds.)

It has been the long-time practice in all principal markets, including bonds, for market-makers to adjust their bids and offers to reflect their relationship with the counterparty; customers that show the dealer a good flow of business get better markets than occasional customers or competitors. It’s a way of rewarding loyalty in what is essentially an adversarial marketplace.

The pre-trade transparency rule tosses this practice on its head. Except that the practice won’t go away, it will just morph. The expectation is that dealers and customers will evolve a new way of communicating, particularly about off-the-run trades. Instead of asking, “What will you pay for $10,000,000 of this bond?” the customer will say something like, “What do you think I could sell this bond for?” The dealer, instead of saying, “I’ll pay 98.26,” will say something like, “I think you could get 98.26, if you made a firm offering.” Suppose the customer were to ask, “Will you pay 98.26?” If the dealer responds positively, he has to show that bid to his competitors. Thus the customer must offer at 98.26, and then the dealer can execute without exposing a bid. The first implication of this is that the trading process will become significantly more cumbersome and time consuming. With everyone going through a language ritual, it will definitely take longer to execute a trade. The second implication is that the buy side is now setting the price instead of the dealer. In off-the-run issues that is a definite change.

And it is in the customer’s setting of the trade price that we encounter the conflict with EU best execution. Best ex applies to both dealers and asset managers, so the buy side now has a positive obligation to obtain the best execution on customer orders. But the dealer is unable to give the customer his best price, if that price is better than the dealer would show his competitors. The price he suggests may be the best the dealer would do, but there is no guarantee that the dealer would execute there until the customer makes a firm bid or offer.

And there is no guarantee that any particular dealer’s quoted price is the best in the market, so the customer may have to go through the same linguistic dance with several dealers, never knowing which one to make a firm bid or offer to. So we can see that two separate requirements, each perhaps commendable in its own right, will combine to produce a very difficult situation for both customers and dealers.

Finding Solutions

The first step in finding a solution is determining the applicability of these requirements for any trade. We can begin with a matrix, so let’s look at one for the EU rules. See Table 1.

You can see, I’m sure, how complicated the decision tree becomes. To top it off, some of these cells are our best guess. For example, do a non-EU firm and a non-EU customer, doing a trade in an EU listed equity, have to trade that on an EU exchange? If they don’t trade there, what recourse would an EU regulator have, since both parties are outside its jurisdiction?

CMA recognized that applying this matrix manually is not practical, so we set about determining the logic necessary for an order management system (OMS) to make these applicability determinations on the fly.  Figure 1 is just the first part of the EU applicability logic. See Figure 1.

There is obviously a lot more logic beyond just this, and additional functions to be performed whenever one of the rules is found applicable, but this functionality is the first step. We have contacted the vendors of most of the major OMS’s globally to find out how much of this capability they currently support, and have not found any that do. We have also asked about plans to build this into their products in time for MiFID’s start date of January 2018. We are still compiling our findings, and would be happy to share them with Rocket 7 readers upon request.

This article was first published in edition 7 of Rocket, our magazine. Download available Rocket editions here, and save your up to date address in your profile to to indicate your interest in receiving a printed copy of the magazine. Copies are also available to purchase and subscribe to via the shop.

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